The large number of ETFs has little to do with serving your best
interests. Below are three red flags you can use to avoid the worst ETFs:

1. Inadequate Liquidity

This issue is the easiest to avoid, and our advice is simple.
Avoid all ETFs with less than $100 million in assets. Low levels of liquidity
can lead to a discrepancy between the price of the ETF and the underlying value
of the securities it holds. Plus, low asset levels tend to mean lower volume in
the ETF and larger bid-ask spreads.

2. High Fees

ETFs should be cheap, but not all of them are. The first step here
is to know what is cheap and expensive.

To ensure you are paying average or below average fees, invest only in ETFs with total annual costs below 0.48%, which is the average total annual costs of the 232 U.S. equity Sector ETFs we cover. The weighted average is lower at 0.26%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows Invesco KBW High Dividend Yield Financial ETF
(KBWD) is the most expensive sector ETF and Schwab U.S. REIT ETF (SCHH) is the
least expensive. Invesco
provides one of the most expensive ETFs while Fidelity ETFs are among the
cheapest.

On the
other hand, Schwab U.S. REIT ETF (SCHH) holds poor stocks and earns our Unattractive
rating, yet has low total annual costs of 0.08%. No matter how cheap an ETF, if
it holds bad stocks, its performance will be bad. The quality of an ETFs holdings
matters more than its price.

3. Poor Holdings

Avoiding poor holdings is by far the hardest part of avoiding bad ETFs, but it is also the most important because an ETF’s performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each sector with the worst holdings or portfolio management ratings.

Figure 2: Sector ETFs with the Worst Holdings

Sources: New Constructs, LLC and company filings

Invesco
appears more often than any other provider in
Figure 2, which means that they offer the most ETFs with the worst holdings.

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. Don’t just take our word for it, see what Barron’s says on this matter.